Bitcoin's derivative data suggests potential for 'short squeeze

Macro traders expecting a continued decline in Bitcoin (BTC) should look at the positioning in the derivatives market, otherwise they risk being caught off guard by a potential short squeeze, a rapid move higher driven by bears abandoning their bearish bets.

For a short squeeze to occur, the market needs to have a higher-than-usual bearish activity. In such situations, a minor price bump can send bears or short sellers running to square off their positions, which, in turn, drives prices further up.

Open interest, or the number of open positions in bitcoin's perpetual futures market, rose to 256,752 BTC early this week, the second-highest daily tally in 365 days, surpassed. by Jan. 4's total of 260,000 BTC, data provided by Arcane Research shows.

Most of these could be short positions, according to data tracked by Laevitas shows the funding rate – the cost of holding long/short perpetual futures positions – has been consistently neutral-to-negative in recent weeks. A negative funding rate means shorts are paying longs to keep the bearish position open. In other words, the market is skewed bearish. That's also evident from the depressed futures premium, also known as the basis, on major exchanges, including the Chicago Mercantile Exchange, a proxy for institutional activity. The three-month premium recently slipped to 1.1% annualized on the CME and 2% on Binance, the world's largest crypto exchange by open interest and volumes.

So, now if Bitcoin turns higher, the cost of holding shorts will become a burden for traders holding bearish positions. And they could offload their bearish bets, putting upward pressure on prices. Bitcoin was last seen trading near 2% higher on the day near $38,900, according to CoinDesk data.

"All [open interest] growth in late April has been accompanied by substantially negative funding rates, suggesting that shorts are the key aggressor while also implying some capitulation from longs after this leg downward," Arcane Research's Vetle Lunde wrote in a weekly research report shared with CoinDesk on Tuesday.

"The sentiment, funding rates, and futures basis [premium] suggest that shorts are the most confident. Thus, a short squeeze is possibly on the table," Lunde added.

While open interest in perpetual futures has increased, the number of open positions in regular futures remains depressed. Perpetual futures differ from regular futures as they lack predetermined expiry. So, perpetual futures positions can be held indefinitely without the need to square off or roll over positions ahead of the expiry.

Open interest as a standalone indicator only reveals the amount of fiat money locked in the derivatives market. However, when combined with other metrics like the funding rate – the cost of holding long/short perpetual futures positions – analysts get an idea about the nature of the positioning.